Taking the Recovery in Stride

March 2016

By&nbspThomas Herbert

Mark Zandi, chief economist for Moody’s Analytics, sees a generally brighter future for the U.S. economy, despite continued volatility and uncertainty. His counsel to colleges and universities: Focus on financial fundamentals and your comparative advantage as an institution.

The U.S. higher education sector still feels the pinch of the Great Recession, in large part because of state funding divestments that have not been returned to institution coffers—and are not likely to return, given the long list of state legislature spending priorities. Most college and university leaders feel stretched to ensure the financial viability of their institutions in the face of expanding academic agendas, mounting deferred maintenance, and increased compliance requirements. Meanwhile, tuition pressures and rising student loan debt raise huge concerns across the sector and beyond.

Even so, Mark Zandi remains upbeat about the state of the U.S. economy, and positive about the potential for colleges and universities to remain relevant long into the future. Zandi is chief economist of Moody’s Analytics, an independent research subsidiary of the ratings agency, where he focuses on macroeconomics, financial markets, and public policy. His latest book, Paying the Price: Ending the Great Recession and Beginning a New American Century (FT Press, 2012), discusses the ways in which top companies worldwide, and government policy—however controversial—have been responsible for a recovery that Zandi considers to be stronger than many are willing to acknowledge.

In this interview with Business Officer, Zandi offers his assessment of the U.S. recovery, remaining fiscal challenges, and what colleges and universities must do to keep pace with an evolving economic landscape and education marketplace.

In your book Paying the Price, you hold an optimistic view of America’s financial future, underscoring the resilience of American businesses and workers, and their ability to adapt to and meet challenges. Yet, we are now seeing significant slowdown in emerging markets, especially in China. We have a stronger dollar, which negatively impacts our trade, and wage growth is slower than we might have expected by this point in the recovery. With all these developments as backdrop, what is the basis for your continued optimism?

Most obvious is job creation. Despite all the headwinds, risks, and threats, the American economy is still generating a lot of jobs. In 2015, the U.S. economy created more than 22.7 million jobs on top of more than three million in 2014. The last time we created jobs at this pace was in the late 1990s in the middle of the technology boom, and one could characterize that period as a tech bubble. There are no bubbles today.

The jobs we’re creating today are based on strong fundamentals. And when you create that many jobs, you are creating all kinds of jobs. This includes lower-paying ones in retail, leisure, and hospitality, but also many high-end positions in technology and professional services—and now even a lot of middle-paying jobs in areas like construction. We’re starting to see jobs in K–12 and in government on the rise. An economy that is creating that many jobs across so many occupations, wage scales, and sectors of the country is indicative of a healthy economy and of positive economic performance.

While it’s true that there are still a large number of underemployed and part-time employees who would like to work more hours, at the current pace of job growth, if sustained—which seems likely—this will happen by midyear. Many more “help wanted” signs will appear in many corners of the country, and at that point the recovery will become more obvious to more people.

After years during which large corporations were essentially stockpiling cash, are more company leaders now feeling confident about investing, going forward?

U.S. companies still have a lot of cash—enough to do everything they want: invest, hire, expand, pay dividends, buy back stock, and engage in mergers and acquisitions. Their bottom lines, profits, and profit margins have never been wider. This is indicative of a healthy corporate America, where companies have the financial wherewithal to do all of the above. Yet, some of the largest corporations are struggling to figure out what to do with all the money. While there is some evidence that they’ve been more cautious about investing in new plants, equipment, software, office buildings, research and development, and so forth, I think that reluctance goes to the long shadow of the recession. For example, if you were running a company seven years ago in the middle of the recession, that was pretty terrifying. You don’t easily forget that.

Likewise, until recently, I think business leaders were quite nervous about the political backdrop in the United States. It was only two years ago that we shut down the government. Those budget battles were disconcerting to watch, and I think that has weighed on the collective psyche. Despite the political bickering back and forth, the government is now operating, we are passing budgets, and everything seems to be coming together so that businesses will gain confidence. Perhaps those animal spirits that are so key to growth will become more evident so that businesses actually begin to increase their investment.

One other point: Even though the economy hasn’t boomed in this recovery, there are some upsides to that. We know from the past that when you boom, that often lays the foundation for a bust. When people forget this cycle, they take on too much debt, banks extend too much credit, and we build stuff thinking others will come, and then they don’t. Mistakes often happen when you get into those boom periods. We haven’t had that during this recovery. That suggests to me that this economic recovery, which is now quite long—going on nearly seven years—has legs and will continue for the foreseeable future.

What is your take on the impact of the oil price collapse and trade-sensitive manufacturing, and do you see those issues pulling back this year?

I did not foresee the collapse in oil prices. I think the policy changes of Saudi Arabia, combined with the massive increase in production of North American shale, are in large part what led to this collapse, which has had a major impact on the global economy, and on emerging economies, in particular. That is where growth has slowed the most globally, and this is showing up on our borders in the form of weaker trade. With our exports under pressure from a rising dollar, our trade deficit has widened. It’s worth pointing out that while oil prices are very low and could go lower—perhaps as low as $20 per barrel—we’re getting pretty close to the lower boundary here. This very dramatic decline, with all it affects, will begin to fade simply because oil prices have nowhere to go but up.

In the United States, the energy sector is now rationalizing, but it’s the only sector of the economy really laying off employees. Trade-sensitive manufacturing is reducing payrolls, but this is very modest in the grand scheme of things. Several thousand jobs a month is not a game changer. The energy jobs are more significant, at 10,000 to 15,000 per month.

And yet, there are positive indicators, including the fact that American consumers have benefited enormously from a decline in energy prices. Evidence suggests they’ve actually spent a fair amount of their gasoline savings. That’s one reason why consumer spending, broadly speaking, is strong by historical standards. Growth on a natural inflation basis is more than 3 percent per annum. That’s about as good as it gets. Pockets of retail are struggling, but, in the aggregate, consumer spending is quite strong.

You mentioned passage of a spending bill that avoided the rancor of a government shutdown. Even so, we now have a national election on the horizon. Would you expect any major changes in domestic or global economic policies if the Republicans win the presidency?

It depends on who wins. If a mainstream establishment Republican or Democrat candidate becomes president, I think there is the potential for some significant policy changes. There is actually a lot of bipartisan support around several major policy areas: immigration, corporate tax reform, infrastructure spending, and trade. There may be ample debate and backbiting to come, but in general, Republicans and Democrats agree on the broad strokes of these policies. That said, getting down to brass tacks and actually ironing out the nuances to get a piece of legislation through Congress and signed by a president will be difficult, and it may not happen even though there is broad consensus around some of these issues. And, of course, depending on how Congress looks in 2016, things could go in lots of different directions.

It looks like global mergers and acquisitions hit a record $1 trillion in 2015, driven at least in part by avoiding U.S. corporate tax rates. What overall effect does this kind of activity have on the U.S. and global economies?

I was in Dublin in mid-December and the first question I was asked was whether we are getting corporate tax reform, because many are afraid we are going to take away this tax benefit and that these inversions will stop. In any given year, I don’t think inversions are a big deal from a macroeconomic perspective. Suppose this activity continues or intensifies, and you look back 10 or 20 years from now. If you had done nothing about it, then you could say this cost the American economy “X” in terms of growth or jobs. And yet, I’m not convinced it is a huge deal at this point. The bigger issue, fundamentally, is why these corporations are inverting. This goes to the need for corporate tax reform.

We all know U.S. corporate tax rates are high relative to those in the rest of the world, and we have these crazy loopholes and exceptions in the code that cost money. Reasonable people could agree we should close or limit those exceptions and loopholes for individual companies and then use that revenue to lower the effective tax rate and make America more cost competitive from a tax perspective. That could go a long way. So, these inversions are highlighting a fundamental problem for which I do think there is a lot of bipartisan support to address. In fact, I think there is a reasonably high probability that something will get done in the next president’s term with regard to a change in corporate taxes, so that inversions become less attractive.

After nearly a decade, the Federal Reserve recently raised interest rates as part of a projected three-year goal of gradually increasing the target rate to slightly above 3.25 percent. What effects do you foresee this policy exerting on the economy?

My view is that interest rates are rising because the economy is getting better, which is more of a positive than a negative thing. Certainly the Fed is sensitive to potential impacts, and it is not going to raise rates unless it feels like the economy justifies it. At the end of the day, a zero percent interest rate, or a quarter or a half of a percentage point is not consistent with a healthy economy. My sense is that a short-term interest rate that’s closer to 3 percent, or 3.5 percent, is where we want to be in the long run. At that rate, everything is working well, people have jobs, inflation is at target, and the economy is growing at its potential.

It’s a fine balance, and there are risks on either side of this, so you do have to get it right. The Fed is certainly hearing from folks who say it is moving too quickly and risks undermining the economy. You don’t want that, because then how do you respond with interest rates so low? Going down the quantitative easing path again doesn’t seem very appealing. On the other hand, if you wait too long you get into that boom-bust cycle where the economy takes off, you get wage and price pressures, and the Fed has to respond. We don’t want that either. So, it’s a matter of judgment and of balance. I’ve had my share of criticism of the Fed, though mostly on the margin. The exact timing of when and how much is more tactical than strategic, and I think strategically it is getting it right.

What implications do you think rising interest rates have for the investment of endowment funds, and especially for alternative investments?

Ultimately, higher rates are consistent with higher returns. If you’re living in a world of zero percent interest rates, it’s tough to generate significant returns—and certainly not the returns that many endowments, pension funds, or insurance companies are assuming. A healthy, normal economy that supports a federal funds rate targeted at 3 or 3.5 percent; long-term bond yields and Treasury yields of 4 or 4.5 percent; equity returns of 6 or 7 percent; and returns on alternative investments at 8 or 9 percent—this is the kind of world in which I think we all want to exist, and hopefully that is where the Fed is leading us. And, if you’re really pushing the envelope, you can go for a low double-digit return for alternatives, although obviously you are taking a lot of risk along with that.

As you know, there are plenty of opinions about the state of American higher education, and many individuals who think the business model is broken. What is your view of our sector’s business model?

I don’t think it’s broken. I do think it needs significant adjustment, since the economic realities of higher education have shifted and continue to change. Institutions have to adapt along a number of dimensions. This includes reining in costs, perhaps through different cost structures and cost-sharing arrangements.

In terms of understanding the market itself, colleges and universities have to become more focused and specialized. They must identify their comparative advantage as an institution—whether that is providing more technical and vocational types of skills, catering to foreign students, or teaching a global education curriculum. They then must articulate that advantage and work hard to expand their market around that advantage to get the students they want. If you plan to be all things to everyone, you’ll likely be toast.

I also think institutions must consider teaming up with businesses. Given how tight the labor market will be in the future, businesses are very interested, and will become even more interested, in developing qualified workers. I think they would be willing to pony up financial resources, equipment, and expertise—including offering their employees as faculty resources—as long as they have some input into the curriculum process. I’ve already seen this happening in different parts of the country, with great success. This could be done more broadly and would, I think, make higher education institutions more relevant.

Now, you could argue that some colleges and universities won’t be around in the future—that maybe we have too many institutions. I do think there will be some rationalization with regard to higher education supply. This is something every industry goes through. Given U.S. demographics—where the 20-something millennials are quickly becoming 30-somethings, and in their wake you have a much smaller demographic pursuing undergraduate degrees—unless you are actively bringing in students from overseas, your institution may have a tough time ahead. Many institutions that are outside of larger urban areas and that aren’t relatively well known may have difficulty attracting foreign students, so we may see more institution mergers or even closures. Obviously there are many moving parts here, and while I don’t think the higher education business model itself is broken, it must be modernized and aligned with the realities of what’s going on around us.

Some people talk about student loan debt as being the next economic bubble. What macroeconomic consequences does this level of debt represent to you?

It’s clearly a problem, and certainly so for students. We’re up to $1.3 trillion dollars in student loan debt. For context, we have $500 billion to $600 billion in credit card debt outstanding. This is double that amount. Auto debt is maybe $900 billion or $1 trillion. Student debt is not only growing rapidly, but the outstandings are growing 5 to 10 percent per annum, while incomes are growing only 4 or 5 percent.

And, there is now evidence that student loan debt is affecting the larger economy. A study came out in July 2015 from Pennsylvania State University and the Federal Reserve Bank of Philadelphia showing that, in areas of the country where you have higher student loan debt, you have less business formation. A major concern for the economy in the long run is that business formation—which is key to our nation’s long-term growth—has weakened since the recession, and student loan debt appears to be a factor. Obviously this is not the only factor, but it’s one example of how this has become a macroeconomic problem.

One concern that some have expressed is that all this debt is going to lead to another financial crisis. I personally don’t believe that, because of the $1.3 trillion in debt, more than $1 trillion is backed by taxpayers and the government. The remainder is private student loan debt for which you have co-signers and good credit underwriting, given mistakes from the past, so this isn’t a financial system problem. It will, however, become a taxpayer problem. Income repayment plans are becoming more prevalent. Ultimately, in the next recession—and there will be one—student loan debt will be a real issue because these repayment programs will be expanded significantly, and that will certainly cost the taxpayer a lot. So, we fundamentally have to rethink student lending because it simply isn’t sustainable in the long run.

Many states are moving toward a performance-based funding model, where the state allots some or all of its education dollars to state institutions that meet certain performance criteria. The goal is to provide an incentive for higher education institutions to improve their products, increase graduation rates, and so forth. Do you see any unintended consequences that could result from such a policy?

As an economist, my intuition is that we all are better served with greater transparency. Anything we can do to improve how we measure things will result in better outcomes. The debate about what we should measure, how we should measure that, and how we present those findings so they provide accurate information are all important questions. With accurate information, people can then make their own judgments about whether they’re getting value. The real problem is that if they don’t have the information, they can’t make that judgment, and then we don’t get good outcomes. Bad schools remain in business, and good schools don’t get the students they should, so transparency is crucial.

Even when equipped with good information, how do you think the average American is likely to respond in the face of ongoing market volatility, such as the Dow plunging 1,000 points in one week as it did earlier this year—sparking fear of another recession on the horizon? What is your best advice for consumers, and for investors, for where to focus to find value amid uncertainty?

The financial market volatility is disconcerting to watch, but I don’t think there is any reason to be fearful. The U.S. economy is on very solid ground, and this will ultimately become evident to investors. Yes, there will be lots of ups and downs as the Federal Reserve normalizes interest rates. That is very typical, but investors should look through the volatility. But recent events are a reminder that if you are invested in stocks or other risky assets, you need to be a long-term investor. If you need your cash next month, next year, or even three years from now, you shouldn’t be heavily invested in stocks.

THOMAS HERBERT is vice president for advancement and executive director of the Miami Foundation, Miami University, Oxford, Ohio.

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Growth on a natural inflation basis is more than 3 percent per annum. That’s about as good as it gets.

In terms of understanding the market itself, colleges and universities have to become more focused and specialized.